Limited Investor Attention and Stock Market Misreactions to Accounting Information

Abstract

We provide a model in which a single psychological constraint, limited investor attention, explains both under- and over-reaction to different earnings components. Investor neglect of information in current-period earnings about future earnings induces post-earnings announcement drift and the pro fit anomaly. Neglect of earnings components causes accruals and cash flows to predict abnormal returns. We derive new untested empirical implications relating the strength of the drift, accruals, cash flows, and pro fit anomalies to the forecasting power of current earnings-related information for future earnings, the degree of investor attention to different types of information, and the volatilities of and correlation between accruals and cash flows. We also show that owing to costs of attention, in equilibrium some investors may decide not to attend to the implications of earnings or its components.